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April 30, 2020
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The combination of the Coronavirus shutdown and the KSA’s (Kingdom of Saudi Arabia) attempted punishment of Russia’s oil producers and America’s shale oil frackers has shocked the Canadian oil industry profoundly. Price collapse happened in a few weeks, and no producers in Canada are profitable at the prevalent prices in the third week of April, 2020. The question in Canada is not how to respond, but how to survive, and the short-term survival options for Canadian producers are few.
Technology: Horizontal Wells and Massive Staged Hydraulic Fracturing
Technology developments in the last 20 years have completely changed the oil and gas (O&G) industry, especially in the USA and Canada. Widespread implementation of horizontal drilling and hydraulic fracturing (HF) has unlocked vast quantities of O&G from strata previously thought to be completely unproductive. First, in the period 2005-2012, this technology took hold in what are called “shale gas” deposits, totally altering the natural gas industry in the USA, then in Canada. Somewhat later, starting in 2010, the “shale oil” revolution began, based on the same technology, and in the United States the increase in daily oil production took an unprecedented upswing, increasing by over 7 MMbopd in a 10 year period. In 2019, the USA became the world’s largest oil producer, exceeding Russia and the KSA. This rise in production is unprecedented in the history of oil in the world.
Figure 1: USA Crude Oil Production History (Courtesy Energy Information Administration, US DoE)
The natural gas production rate increase in the USA is less startling (Figure 2), but it also has had a large impact in North America. Natural gas and oil are not equivalent products: they serve different markets and have different transportation and storage modes. For example, exporting crude oil is relatively straightforward and the world is well equipped with supertankers, whereas natural gas travels mainly by pipeline, and cross-ocean exports require costly liquefied natural gas (LNG) facilities and new special tankers for highly chilled LNG. Natural gas (CH4) is used mainly for heating and electrical power generation: the USA has reduced its CO2 emissions faster than any other country by building new natural gas power plants, replacing old coal-fired plants as they reach the end of their lives. Oil is used mainly for transportation, but is also the basis of a rich petrochemical industry that touches every aspect of our lives. Oil will go on; perhaps at a slower pace.
Figure 2: USA Natural Gas Production Increase (Courtesy Energy Information Administration, US DoE)
How has the USA Shale Gas Revolution impacted Canada?
Thanks to the new technologies, there is almost certainly enough producible natural gas in Canada in our shale gas deposits such as the Montney Formation in British Columbia and Alberta, the Frederic Brook Shale in New Brunswick and Prince Edward Island, and the Utica Shale in Québec to supply current annual production for 2000 years. However, the USA, our only international natural gas customer, has also dramatically ramped up natural gas production from shale (Figure 2); they no longer need our natural gas, and this will be the case for the foreseeable future. Our TransCanada natural gas pipeline from the west is running at a fraction of its capacity as Ontario and Québec suppliers shift to cheaper natural gas sourced from Ohio and Pennsylvania. As contracts expire, the USA is importing less and less natural gas from Canada, and it is entirely possible that Canada could become a net importer of natural gas at some future date. So, drillers await the completion of LNG facilities on the west coast of Canada, as there is currently a glut of production.
Supply companies in Ontario and Québec are more and more importing natural gas from Ohio and Pennsylvania because it is cheaper than natural gas from the West, so the TransCanada natural gas pipeline cannot easily compete because of the transportation costs. These companies are happy to take the opportunity to access cheaper gas from the USA. Alberta and British Columbia natural gas producers are ham-strung because their products cannot be shipped to the east competitively.
It will be years before Canada starts exporting LNG; the British Columbia government tried to get LNG export facilities underway as early as 2012, but met huge opposition, much of which has abated and been overcome by Court rulings. NG producers in the Montney play will admit that they can make money at $1.25-1.50/Mcf, but if no one is buying, price is almost irrelevant to a producer. Investing in natural gas players seems like a poor bet in the next few years. Even when the LNG terminal(s) are build on the west coast, by then the international price of NG might also have collapsed, as there are more and more suppliers, but reduced demand. Oman, Australia, Trinidad and other countries are building LNG facilities. Russia exports large amounts of natural gas to Europe. Kazakhstan and Russia export to China. Competition ramped up as Canada delayed decisions. When LNG facilities are available, it will have little impact because of the pent-up productive capability that currently exists.
And the Shale Oil Revolution in the USA?
There is a great deal of light oil and natural gas liquids (ethane, propane, butane and pentane) that is being produced in Canada from the Duvernay and the Montney liquids-rich shale gas and shale oil plays. Unfortunately, the very low molecular weight liquids co-produced from the Montney along with the April 23 2020 natural gas and the light oils from the Duvernay are not very good for making diesel oil or jet fuel. Hence, there is a glut of low molecular weight liquids (“pentanes plus”, or “naphtha”) in North America because the oils from the Bakken, Permian Basin, and Eagle Ford plays in the United States are all very light oils, so the American refineries are not enthusiastically purchasing our light oils like they used to. Having all light molecules is not good for the range of products that must come out of a refinery, and it is challenging to retool refineries used to taking in a particular blend of oils to accommodate a significant change in their feed stocks. Refineries are tooled to take a limited mix of molecules, and to retool a refinery to accommodate a large change in feed stock means a long shutdown, a year for conversion, and a few 100 million dollars, and that is not a large refinery.
But, the glut of light molecules it also means that the USA refinery industry has a deficiency of high molecular weight oils to add to the low molecular weight oils to achieve a better balance going into refineries to create a suitable range of products to meet market demand. So, the refineries that are “flooded” with very light oils still need our heavier synthetic oil, they just currently have too much of all kinds of oil because the product demand for gasoline and diesel has collapsed.
Do the Oil Sands have a Future?
The oil sands have likely seen their last oil sands mine for a number of reasons, although there will continue to be small developments by the current mining projects to sustain output at current levels, given a reasonable price. For a guess, $60/bbl is probably what the newer mines can operate at if they struggle to be highly efficient. The older mines (Suncor and Syncrude) that made their investments in a different era can squeeze by with a lower price for their Synthetic Crude (which has a much higher value than raw bitumen of course), figures of $40 for Suncor, $45-55 for Syncrude Canada Limited have been suggested. Given the very low current interest rates, it is possible for operators to restructure their debt. Also, the oil sands mining operations benefit from a government in Alberta that treats them very well in terms of deferred reclamation and waste management costs, wage subsidies, low royalty rates, and so on. Likely, the newer mines can limp along at $60/bbl for synthetic oil, but the oil prices in April of 2020 are disastrous for them.
The steam-assisted gravity drainage operators will survive at $30-45 oil, but the carbon footprint for those operations is much larger than mining (vast quantities of natural gas are used to generate steam), and the current government in Ottawa is apparently not in a pro-oil industry configuration, focusing instead on climate and environmental issues, and with strong plans for decarbonizing the energy industry. The federal government is therefore loth to do much to facilitate production of bitumen and heavy oil. What is the future for oil sands mines if there is no price recovery above $40/b? This is difficult question to answer. It is hard to conceive of the Alberta government allowing a big oil sands mining project to be permanently shut down, but these are difficult times. The low-cost bitumen producers using steam processes in good assets are going to survive better than the others in the bitumen business. It is likely that many marginal steam projects will be curtailed, especially since these producers have to refining and marketing capabilities.
World Oil?
What about the future for oil itself? OPEC countries agreed to cut production by 9.7 MMbopd in April 2020. However, by April 23rd, demand appears to be down by 25 MMbopd, and the price crashis causing real problems for KSA and Russia as well as oil producers everywhere. 80% of KSA’s economy is based on oil royalties; Russia depends economically on oil and natural gas exports to Europe. Even in Canada, the O&G sector is the largest contributor to the country’s GDP (Gross Domestic Product). Shale oil April 23 2020 producers in the USA will be hurt, for sure, as many of them were financed at an assumed price of $45/b or even $60/b; many small companies will have to declare bankruptcy. Most pundits believe that the sharp rise shown in Figure 1 peaked in March/April of 2020, and will not return to continued production growth as the economy recovers. Producers will focus on re-stimulation of older wells to increase production temporarily, and to complete hundreds of existing drilled wells that remain uncompleted. They are also likely to be ruthless in cost-cutting, in shutting-in uneconomic wells, and in forcing down the prices charged by service companies for hydraulic fracturing, well testing, and equipment.
Shale gas as an industry has not proven to be a highly profitable industry for large oil companies because the small producers have, to date, been reasonably well financed (massive debt financing), very good at cost-cutting, excellent at rapid implementation of new ideas to reduce costs, and so on. Over a long history of economic activity, one should never under-estimate the USA’s oil industry, or the American economy in general. They have a remarkable record of rapid redeployment and rebound.
Because of the advice to continue social isolation and relax it slowly, a highly probable slow economic recovery, a recovery in international travel (and cruises) that may take many years, some deinternationalization, etc., it seems improbable that the World oil demand will get back to 100 MMbopd for a long time. Some say that peak oil was reached on January 01, 2020, and that the world oil industry will never again reach 100 MMbopd. Remember that the technologies for more renewable energy sources, for large-scale energy conversion and storage, and for electrical transportation vehicles and systems will continue to progress rapidly. Some portion of the “recovery” will be harvested by these new technology approaches, but good luck in picking winners because of government policies.
Some of our habits will change. Conferences may have to struggle to get physical attendance back up to pre-COVID levels for many years. Cities may aggressively advance larger-scale rapid transit. Activists may succeed in impeding further oil industry growth in liberal open economies like Canada’s. It is well to remember that only the United States and Canada are dominantly democratic among the ten largest oil producers. Also, Canada is the largest oil-exporting democracy, but the quality of our oil is poor, and it has a large environmental impact, even with our much more stringent controls. Don’t ever count on the world buying Canada’s “Ethical Oil”; the world will always buy “Cheap Oil”, supporting some pretty shady politics, allowing huge transfers of ill-gotten gains to Swiss banks and the Cayman Islands (as usual), and wringing their hands publicly about these matters. Hypocrisy? Yes. Everywhere.
Investing in Oil and Gas?
An investor who believes that now is the time to purchase oil stocks must be very clear eyed, looking at companies that have an array of solid assets in conventional oil with less exposure to the oil sands and to the natural gas sectors, or even to the heavy oil sector. Nevertheless, oil is what refineries need to produce their product array, society still demands a lot of oil, and many refineries have been tooled to take a mix of heavy and light oils. An investor should look at the cash reserves of Canadian companies because they will have to spend much of that money to stay alive. Examining debt to net-present-worth ratios is critical because debt-heavy corporations don’t have breathing room in the current low-price climate, and are unlikely to bounce back from the current crisis in demand.
There are wide-spread opinions that integrated Canadian corporations like Husky, Suncor, and IOL will do better than pure production companies like Devon, Crescent Point, and Encana (now Ovintiv Inc. and moving to the USA). This is because companies with refining and marketing sections can continue to profit at some level on the refining and sales side, and may even benefit overall from being able to access extremely low-cost feedstock oil. For example, a refining company like Valero in the United States can continue to purchase cheap oil and achieve reasonable margins. (Nevertheless, their stock value was cut in half during January to April in 2020).
The era of oil is not over, but the idea of “running out of oil (or gas)” is as dead as a doornail, given production technology developments in the last 20 years. Vast oil use in petrochemicals and transportation will decline only slowly. There is some talk of the possibility of striking a North American agreement (including Mexico) to set a floor price of about $45/b, at which point import taxes would kick in on any imports from outside NA to bring the equivalent price to that level. This is unlikely to happen because of the current USA administration and the challenge of doing a deal of this type. There will be large subsidies for the USA oil industry who have been strong supporters of the policies of the current administration, and that will not help Canadian pure producers, as far as can be determined. Direct subsidies to Canadian producers are unlikely to come from the Canadian federal government, who have demonstrated a view that the oil industry is a “sunset” industry in the long term.
A probable outcome of the USA federal gov’t support of the oil industry will be that the larger companies will survive and prosper; the small independents, not so much. Inequality will rise, as the lowest workers will get squeezed, but the Executive Suite bonuses will remain. Some will agree with this, most will not. Stay well in these interesting times. I hope Canada does well, and life will go on, somewhat changed, hopefully for the better in the long term.
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